Focus on efficient tax design

The forthcoming Union Budget needs to be a policy tool to assuage investor sentiment, boost investment and purposefully reduce the markedly overextended finances of the government. And the way ahead to shore up investor confidence would be to legislate on tax policy that provides for certainty and predictability, and eschews nasty surprises so that taxpayers can make rational economic choices in the most efficient manner. Note that one or more amendments of the law in the Finance Act, 2012, for instance that pertaining to tax-treaty override, have “raised the ire of foreign investors and generated an atmosphere of deep uncertainty”, as per the Shome committee.

It was all part of the rather hasty move on retrospective taxation in the Act. The expert panel report has now recommended re-amending the relevant subsection in the Income-Tax Act, so as to ‘refrain from treaty override’ going forward, as tax treaties — such as with Mauritius — have an overriding status over domestic law. Stakeholders would certainly be looking at the fine print in the Finance Bill for reassurance and reversal to the status quo. But the larger issue is of effective pre-legislative scrutiny of tax proposals — particularly those that have huge economic implications — the idea being to rev up transparency and accountability in tax design. For sound scrutiny and follow-through advice, we do need institutional processes, remedies and proactive policy on tax matters.

The Shome committee on General Anti-Avoidance Rules (Gaar) in the tax domain was duly constituted following the Finance Act last year, to undertake consultations, finalise guidelines and to provide greater clarity on a host of implementation issues.

And finance minister P Chidambaram has lately stated that the major recommendations of the expert committee have been accepted, with some modifications. It has also been reiterated that while tax mitigation efforts on the part of taxpayers, such as locating in a special economic zone to avail tax benefits, are well recognised, tax avoidance, though technically legal, is frowned upon in tax regimes. Tax evasion is, of course, plain illegal.

However, in implementing the new norms, we do need to proceed with caution, take into account investor concerns and abide by the generally-accepted cannons of taxation such as certainty and predictability.

The Shome panel did call for deferring implementation of Gaar by three years, and the Centre has now decided to do so by two. Other suggestions have been accepted in toto, for example, only arrangements that have the main purpose (and not one of the main purposes) of obtaining tax benefit should be covered under Gaar; and a monetary threshold of .`3-crore tax benefit has been prescribed for the new norms.

Further, the idea of an Approving Panel to invoke Gaar has been accepted, albeit with fewer independent members, and its decision would now be binding on both the assessee and the I-T authorities. It may make sense to provide for tribunal appeal for greater judicial scrutiny. Note also that the FM statement on Gaar is silent on treaty override. The Shome panel did suggest that the clause on override be amended, where the tax treaty “itself addresses the issue of tax avoidance”. It is a major recommendation indeed. It seems clear that what is on the cards is to follow parliamentary procedure and amend the subsection on treaty override that is now the law of the land, in the Finance Bill.

As the expert report mentions, Sections 90 and 90A of the I-T Act grant the legal authority to the executive to enter into an agreement for avoidance of double taxation (DTAA) with another country and specified territory. But provided that a taxpayer may choose any provision between domestic law and DTAA, whichever is more beneficial. However, in the Finance Act, 2012, subsection 2A was inserted, which says, “…the provisions… shall apply to the assessee, even if such provisions are not beneficial to him”.

Just a few words can make tax treaties quite infructuous! The committee report has outlined how the tax treaty with Mauritius addresses avoidance by requiring tax residency certificate and that with Singapore, a minimum annual expenditure on operations. We do need to reamend the Act so that tax treaties have an overriding status over domestic law. It would add to investor comfort; the fact remains that much of our foreign direct investment and foreign portfolio flows are routed via DTAA regimes.

In future, there would be scope to tighten the norms in the main DTAAs, but we need stability in our tax and policy regime to obviate the need to route funds in roundabout ways. The bottom line is that by increasing prices and lowering quantities sold, taxes impose solid losses on consumers and producers alike.

The sum of the costs almost always exceeds the revenue that the taxes raise. The extent to which they do so is the deadweight loss or the social cost of a tax effort. Hence the pressing need for efficient tax design to mitigate the losses.